Goldman Sachs Eyes Volcker Rule Workaround for Buyouts

Published 5:45 PM ET Mon, 4 March 2013
Reuters

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Goldman Sachs is trying to work around a financial reform regulation to keep investing in the profitable, albeit risky, business of buying and selling companies, three sources familiar with the new business said over the past week.

The Volcker rule — named for former Federal Reserve Chairman Paul Volcker and part of the Dodd-Frank financial reform law — is expected to limit bank investments in private equity funds, but not necessarily private equity-style investments outside of a formal fund structure.

In a bid to pool money for deals without raising a private equity fund, the Wall Street bank has been lining up clients who are willing to put money into accounts set up to invest in private equity-style deals, the sources said. Goldman would also set aside some of its own money and partner capital into separate accounts for the same purpose, they said.

Under the new plan, Goldman would then make investments in a syndicate fashion, contributing investor money, along with its own capital and partner dollars, the sources said.

That would be different from a traditional private equity fund, where money from various investors has already been pooled together in a formal fund structure.

"It is the same pitch as before, 'We are putting a lot of our own money in this,'" said a person familiar with Goldman's marketing of the new business. "They are saying, 'We are still in this business.'"

The details of the new structure, including whether Goldman would still get fees for managing client money and how profits would be taxed, could not be learned.

Goldman spokeswoman Andrea Raphael said on Monday that the firm is merely taking a strategy used in other investment businesses and applying it to private equity.

"We believe these investments will continue to be important to our clients and the economy, more broadly," Raphael said. "We will, of course, comply with all aspects of the Volcker rule as it is finalized."

Volcker Rule

The Volcker rule aims to limit banks' exposure to these kinds of investments. The rule, which has not been implemented yet, will allow firms to place up to 3 percent of their Tier 1 capital into private equity funds. It will also prevent them from contributing more than 3 percent of any new private equity funds they raise.

A draft version of the rule appears to allow banks to continue making private equity investments, as long as the investments do not reside in a fund structure.

"It's not a model of statute writing," said Dwight Smith, an attorney at Morrison & Foerster who focuses on bank regulation. "In terms of merchant banking and direct investments in portfolio companies as opposed to investing in funds, those are fine and not subject to Volcker at all."

Some major banks such as Bank of America Corp and Citigroup have been pulling back from private equity investments ahead of the rule. But others, including Goldman and Wells Fargo, are betting that workarounds will help them retain at least some lines of business.

Returns from private equity investments can be high. But they are also risky. The largest leveraged buyout, the $45 billion takeover of Texas utility TXU in 2007, has turned into one of the most spectacular failures of the last decade's buyout boom. Goldman was part of the private equity consortium that took TXU private. The company is now known as Energy Future Holdings.

Since the financial reform law passed in 2010, Goldman has shut down its proprietary trading desks and outlined plans to gradually wind down its stakes in hedge funds each quarter to prepare for Volcker rule.

But it also gathered a team of lawyers, lobbyists and strategists to devise arguments that would protect as much of its proprietary investing business as possible, sources said.

The central argument that emerged from their effort was that activities like merchant banking and debt investing through credit funds should be exempt from the rule — or parts of it — because they are akin to making loans, the sources said.

Partner Money

Goldman has a long history of successfully raising private equity funds that mix its own capital with money from employees and clients. GS Capital Partners VI, the largest such fund Goldman raised, closed in 2007 with $20.3 billion in assets, 45 percent of which came from the firm and its partners.

Goldman's private equity assets represented 19 percent of its Tier 1 capital at year-end, though it is not clear how much of those assets are tied up in funds.

Goldman partner capital is also invested in other types of investment vehicles, such as credit funds, and the firm has been trying to make sure they are exempt from Volcker restrictions as well.

In a February 2012 meeting with the Federal Reserve, for example, Goldman executives argued that credit funds should not be subject to Volcker restrictions because investors typically require a 5 percent "skin in the game" from sponsors.

Goldman's private equity and merchant banking businesses are large and lucrative, and hold a sizable portion of the personal wealth of senior Goldman executives, including chief executive Lloyd Blankfein, one of the sources said.

Goldman is betting that its investments not tied up in funds will be protected from Volcker rule.

Members of Goldman's regulatory reform group — overseen by Harvey Schwartz, who is now chief financial officer, and John Rogers, who is chief of staff — have given presentations to regulators about potential pitfalls of Volcker, and tried to educate the Fed and other regulators on the best way to write the rule, sources have said.

One source who attended meetings with regulators said that officials seemed receptive to Goldman's arguments, but cautioned that they worried about banks becoming overexposed to risks in private equity investing.

New Private Equity

It is unclear when the final Volcker rule, which had been scheduled for July 2012, will be unveiled. It may not be fully implemented for years to come.

In the meantime, a group of Goldman bankers, in the merchant banking division headed by Richard Friedman, have been pitching clients on the new way of co-investing in private equity deals with the firm.

Tanya Barnes, a newly minted managing director, is one person working on the project, sources said. Barnes has a background in distressed debt investments and previously worked in Goldman's Special Situations Group.

The firm has been upping its marketing game to persuade clients that the deals are worth their time, even though they are not in a traditional fund, one of the sources said.

Smith, the attorney, said banks may still be required to reduce exposure to the merchant banking business.

"The Federal Reserve has this inherent authority to tell banks not to do things even though it's technically legal for them to do so," he said. "The Fed could look at a bank's array of merchant banking activities and just say, 'Look, that's too much, even though you haven't triggered the Tier 1 capital limitation.'"